Our own worst enemy

MarshallLoeb

NEW YORK (CBS.MW) - "The investor's chief problem, and even his worst enemy, is likely to be himself."

So said Benjamin Graham, the hugely successful investor and legendary theorist who taught Warren Buffett, among so many others.

Today, a growing number of scholars are studying a hot field: The often irrational behavior of investors -- why they do what they do, and why they often wind up being their own worst enemies.

For example, Barbara Poole, associate professor of finance and insurance at the American College in Bryn Mawr, Pennsylvania, has surveyed 400 people about their money goals. Most respondents cited wealth accumulation, but surprisingly large numbers saw money mostly as a means of achieving status or keeping score or controlling other people.

And when people have bad experiences with money -- an investor, say, gets burned -- the memory lingers. As Poole writes, "Individuals tend to weigh negative past experiences more heavily than positive past experiences. Studies have shown the pain individuals experience with losing $1 is about twice as great as the pleasure they experience with gaining $1."

Now a highly instructive book has been published by Financial Times/Prentice Hall, and the title tells it all: Investment Madness, How Psychology Affects Your Investing...and What to Do About It. The author is John R. Nofsinger, a finance professor at Washington State University, and he calls on numerous academic studies to back his main points.

"Overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events."

Psychologists, he says, "have found that men are more overconfident than women in tasks that are perceived to be in the masculine domain...Investing has been considered a masculine task. Therefore, men will generally be more overconfident about their investment decisions than women. As a consequence, male investors trade more frequently than female investors -- their portfolios have a higher turnover."

Two financial economists, Brad Barber and Terrance Odean, examined the trading behavior of nearly 38,000 households that took place through a large discount brokerage from 1991 to 1997. They found that single men trade the most -- at an annual turnover of 85 percent -- compared with an annual turnover of 73 percent for married men. Married and single women have an annual turnover of 53 percent and 51 percent, respectively.

"As you acquire more information, your confidence in your ability to predict the future rises far faster than your true ability. Online investors have access to vast quantities of data, but information is not knowledge or wisdom. In fact, having loads of data gives you the illusion of knowledge and thus control. Ultimately the data may give you a false confidence that you can pick stocks."

Due to the illusion of control, investors have become even more overconfident after switching from traditional brokerage trading to online brokerage accounts.

Barber and Odeon, Nofsinger reports, studied the behavior of 1,607 investors who converted from phone-based trading to online trading. Even before going online, these investors were active traders -- their average annual turnover was 70 percent. After the switch to online trading, the annual turnover increased to 120 percent.

"Was this extra trading fruitful? Before the switch, these investors performed well. Their portfolio returns (after costs) exceeded that of the major indices (like the S%P index). After the switch to online trading, these investors began underperforming these indices. In short, it appears that they became more overconfident after switching to online trading accounts.

"Overconfidence leads to excessive trading that can lower portfolio returns. Overconfidence also leads to greater risk-taking. Finally, investors' ever-increasing use of online brokerage accounts is making them more overconfident than ever before."

For all this, people often have a status quo bias, Nofsinger says. They have a tendency to keep what they have been given instead of exchanging it.

People also have an attachment bias. They can become psychologically attached to a security, seeing it through rose-colored glasses.

"Fearing regret and seeking pride causes investors to be predisposed to selling winners too early and riding losers too long.

"After people have experienced a gain or profit, they are willing to take more risk. Gamblers refer to this feeling as playing with the house's money. [But] after experiencing a financial loss, people become less willing to take risk. This is the snake-bit or risk-aversion effect.

"You tend to seek risk or minimize the effects of risk when you have big gains. Alternatively, you tend to avoid risk or overestimate risk after experience big losses. This behavior contributes to stock market bubbles. The psychological bias of seeking (or ignoring) risk of the house money effect contributes to creating a price bubble. The psychological bias of avoiding risk in the snake-bit effect tends to drive stock prices too low."

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